Distorted Housing Market Gives False Hope

The housing market's rebound is being misconstrued as a real recovery, and there's more here than meets the eye, especially as unemployment is stubbornly high, even without the negative contribution of the shrinking labor force participation rate. The housing data is being taken at face value, and as recently as May of this year, Fed members wanted out of the mortgage business.

A trio of hawkish regional Federal Reserve officials are calling for the U.S. central bank to stop buying mortgage-backed bonds, citing the recent improvement in the housing market.

The strongest foundation supporting Bernanke's confusing hint of a QE pull back can be found in the FOMC's June 19 statement indicating that "the housing sector has strengthened further." Markets responded in kind, further frustrating the Fed. But Bernanke didn't explain "Why," the fifth "W" that is often left out of a well constructed question sequence - Who, What, Where and When.

Looking at the most recent National Association of Home Builders/Wells Fargo housing-market index, the increase to 52 in June from 44 in May - the first time the index reached positive territory since April of 2006 - feeds into the assumption that the less than reliable linear economic theory, a Fed favorite, will prevail.

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But the sudden increase in interest rates has the Fed freaking out, because they know the true story. Certainly they are worried about inflation because they don't know any better, but also realize that QE hasn't delivered the goods. In addition, housing strength is less than impressive considering that we're far from the average 30-year fixed-rate mortgage rate of 6.41% during 2006, according to Freddie Mac. In addition, the most recent rate of 4.46% -- a jump of 53 basis points from 3.93% in only one week -- is still 1.95% below the 2006 average, and if mortgage rates move up to historical averages, what will happen to home sales when unemployment hasn't recovered one iota?

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As the chart above illustrates, when unemployment is adjusted for labor force participation rate, a fact that cannot be overlooked, we still have an extremely feeble labor environment, and far worse than the official rate implies. However, and without a doubt, there's a sense of revived interest in real estate and I shall provide anecdotal evidence. On the street where I live, seven houses were sold in the last 30 days, and judging from the activity one would assume that all is well. However, not a single house sold for the asking price, and the price reductions leading up to the sales, not increases, varied between 3% and 7%.

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The celebratory mood was visible when the most recent S&P/Case-Shiller Home Price Index registered an annual gain of 12.1%, but according to the chart above, house prices have only stabilized from depressed levels, despite the headline grabbing year-over-year increases. While inventories are tight, according to the National Association of Realtors, the underlying contributory factors are not making the rounds. The implication here is that traditional buyers are coming to market, but the reality is different because "cheap money bankrolls Wall Street's bet on housing."

The once-beleaguered Las Vegas housing market has been on fire since investment firms led by Blackstone Group LP, Colony Capital and American Homes 4 Rent began buying homes here some eight months ago, backed by $8 billion in investor cash to spend nationally. These big investors and a handful of others have bought at least 55,000 single-family homes across the U.S. in the past year. In the Vegas area alone, they have accounted for at least 10 percent of the homes sold since January 2012, according to a Reuters analysis of housing transactions.

That is not the much needed organic growth! Back in February the NAR said that "roughly 32 percent of all single-family homes were purchased in all-cash transactions," while historically "all-cash deals have represented no more than 20 percent of all transactions." The easy conclusion is that past demand will dry up! In addition, "private equity firm Cerberus Capital Management wants to provide financing to small investment firms that are buying foreclosed homes as part of a long-term bullish bet on the housing recovery." The keyword here is "bet," and a housing recovery cannot materialize unless common folk are out in force buying their caves, especially as unemployment lingers and incomes are stagnant.

What's wrong with this picture? Unlike the traditional buyer, Wall Street is not planning to hold these properties for the long term, and an old fashioned investment exit is in the cards. In addition, turning these properties into rentals is not sustainable long-term due to the absence of economies of scale found in multi-family units, while risk exposure for single family homes is very different from multi-family units, because when a single family rental loses its tenant, it loses 100% of revenue.

An interesting Quarterly Report to Congress (pdf) by the Special Inspector General for the Troubled Asset Relief Program (SIGTARP), quietly delivered an additional worrying development.

SIGTARP is concerned that the number of homeowners who have redefaulted on a HAMP permanent mortgage modification is increasing at an alarming rate. Treasury's data shows that the longer a homeowner remains in HAMP, the more likely he or she is to redefault out of the program. As of March 31, 2013, the oldest HAMP permanent modifications, from the third and fourth quarter of 2009, are redefaulting at a rate of 46.1% and 39.1%. HAMP permanent modifications from 2010 also had high redefault rates, ranging from 28.9% to 37.6%.

Meanwhile, the Home Affordable Modification Program, "a federal program that helps troubled homeowners receive modified mortgages, is being extended by two years" as interest rates rise. Student loans, an apparent unrelated wrinkle that complicates the housing industry, will prevent first time buyers from jumping into the market, and the food chain is crucial to the real estate industry because in most cases buyers are also sellers.

The amount of student loan debt issued in the US has nearly tripled from $350 million in 2004 to nearly $1 trillion in 2012, making it very difficult for the mortgage industry to find first-time homebuyers - a critical element of a functioning housing market

Despite the appearance of a housing recovery, the Mortgage Bankers Association stated in May that "the delinquency rate for mortgage loans on one-to-four-unit residential properties increased to a seasonally adjusted rate of 7.25 percent of all loans outstanding at the end of the first quarter of 2013, an increase of 16 basis points from the previous quarter, but down 15 basis points from one year ago." Obviously the foreclosure problem persists because the delinquency rate is still well above the "historical average of 1 percent to 2 percent."

Returning to Wall Street, the ultimate objective is to profit from price appreciation, not rental income, although a name has been given to the strategy -- "REO to Rental, with REO standing for 'real estate owned'" -- and financial creativity is once again finding its way into the investment world.

The hedge funds and private equity firms who have bet on the REO to rental market had a more sophisticated exit strategy in mind than simply flipping their properties to the next sucker. The plan has been - and still is - to sell the cash flows from rental income and property sales, by using them as collateral for bonds. Investor appetite for such REO to rental securitizations, though, may have been overestimated, not least because the bonds are riskier than Wall Street claims. Rating agencies say the dangers include not just another economic downturn, but also failures on the part of the rental property managers, and risks associated with the lack of historic precedent for the REO to rental market.

The hedge fund game has been in play for a while now, and here's another example that was reported last year, while highlighting that economies of scale are a problem.

"We view (single-family housing) as a real continuation of our strategy," Cogsville said, adding that his company wants to buy more homes to gain economies of scale needed to manage scattered properties. "It is different, but it's doable." Cogsville offered $11.8 million on the Chicago homes, putting $2 million down and agreeing to pay the rest over time by splitting rental income with Fannie Mae. What remains to be seen is how the new ownership will affect neighborhoods, and how long investment firms will stick around if prices rebound.

Although there's plenty that Bill Gross has added to the investment discussion as of late, there's only one statement that he made that is in line with my observations.

The Fed itself may be driving in a fog to think that it's a cyclical as opposed to a structural problem in terms of our economy.

What Mr. Gross misses is that this is a structural problem within an extremely misunderstood cycle which is far more refined than Kondratieff ever envisioned. I do maintain that the Fed doesn't have a clue as to what it is doing, and, worse yet, does not know what to do. To ensure that the current status quo is not disturbed, Fed members have been out in force engaging in damage control, and the message is that "the Federal Reserve will be keeping monetary policy very simulative for years to come," according to Federal Reserve Bank of Atlanta President Dennis Lockhart.

The observations above are not so much about real estate, but rather about the broader economy and stock market and how investors are banking on a recovery that will prove to be illusive and disappoint plenty of experts, and although the process always develops in slow motion, it will become apparent in 2014.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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